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Brexit Reflections - Fiscal implications for the Scottish Government

David Eiser discusses what the Brexit vote means for the Scottish Government’s budget in the short and long term.

What does the Brexit vote mean for the Scottish Government’s budget? In the short-term, (i.e. until the UK formally leaves the EU), the answer essentially depends on two things. First, how much the UK fiscal outlook worsens as a result of the subsequent economic uncertainty. Second, how the UK Government decides to react to this. In the longer term, the arrangement that the UK Government comes to with the EU will influence the extent to which Brexit results in a wider set of fiscal responsibilities coming to the Scottish Parliament.

The UK economy has now entered what is likely to be a prolonged period of uncertainty which will reduce economic growth and cause a substantial worsening in the UK fiscal outlook. Before the referendum, Chancellor George Osborne had threatened an ‘emergency budget’ in the weeks immediately after a leave vote, with tax rises and spending cuts in order to meet his self-imposed fiscal rule that the UK should achieve a surplus on the public finances by 2019/20. The IFS estimated that the UK budget deficit in 2019–20 would be £20 to £40 billion higher as a result of a Brexit vote and the subsequent economic slowdown.

But thankfully we are being spared the punishment Budget. Osborne announced on Friday that his fiscal surplus target was being abandoned (announcing her bid for leader the previous day, Theresa May had already indicated she would ditch the target). In reality, it was already looking unlikely that he would achieve the target even before the referendum result was announced, based as it was on some fairly optimistic forecasts about productivity and wage growth. And the target always did contain a get-out clause – the rules allowed a relaxation of the fiscal surplus target if real GDP growth fell below 1% per year, which now does not look unlikely.

Rather than further fiscal tightening – which clearly would have had an implication for the Scottish Government’s block grant – it seems likely that the UK government will simply borrow more. The good news is that, despite various credit rating agencies downgrading UK government debt, government borrowing costs have fallen since the referendum result as investors desperately seek safe havens for their assets.

But this does not necessarily mean looser fiscal policy or an end to austerity. The government seems likely to rely on further reductions in interest rates to cushion the effects of economic slowdown. In fact, if the fall in the pound leads to higher inflation and wage pressures, existing departmental allocations will buy less. In other words, even with no change to existing cash terms allocations, higher inflation effectively means a larger cut to the Scottish Government’s real terms block grant.

Nothing however is known with any certainty until the Autumn Statement. The OBR, which was due to produce updated economic and fiscal forecasts in July, has put this exercise off until autumn too.

Beyond the initial renegotiation period, Brexit is likely to have further fiscal implications for the Scottish Government, although there remain huge uncertainties around what these may look like.

If Brexit removes an obligation to adhere to EU law (this remains a large if), then the Scottish Parliament will gain legislative competence in the areas of agricultural, fisheries and environmental policy. Because these policy areas are not explicitly ‘reserved’ to Westminster under the 1998 Scotland Act, the presumption is that they will come under the remit of the Scottish Parliament following Brexit.

New legislative competences are all well and good, but how will these fiscal responsibilities be funded? At least part of the UK’s annual contribution to the EU, currently around £14.5bn (net of the rebate), will be repatriated to the UK Government. (How much of the £14.5bn is repatriated depends on the nature of the deal that the UK strikes with the EU. Norway makes an annual contribution of around £0.5bn to the EU as a condition of its membership of the EEA. If the UK made an equivalent contribution in per capita terms, this would equate to some £6bn.)

How the UK Government might then allocate any repatriated resources to the Scottish Government to reflect new policy responsibilities is up for debate. Allocating funding for agriculture, fisheries and the environment on a per capita basis is likely to be seen as unfair (Scotland accounts for 8% of UK population, but currently receives 18% of the EU Common Agricultural Policy funds that flow to the UK). The solution will require negotiation between the UK and Scottish governments, and amendment to Scotland’s Fiscal Framework.

Brexit might also reopen the debate on tax devolution. EU rules prevent VAT from being devolved within member states, which is why VAT revenues are only being partially assigned to the Scottish Parliament under the Scotland Act 2016. EU rules also create barriers to the devolution of alcohol and tobacco duties, taxes for which there is a reasonably strong case for devolution.

So Brexit creates significant uncertainties around the Scottish Government’s fiscal position in the short-term, and raises questions about the scope of Scottish Government fiscal policy in the longer term. All this creates significant distraction at a time when the Scottish Government is still getting to grips with its new tax, welfare and borrowing powers.

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